A day before the US voted to elect its 45th president, former chairman of the Federal Reserve Alan Greenspan predicted in an interview to Bloomberg that interest rates would rise. He claimed that the economy is moving into the early stages of inflation acceleration, and bond yields would begin to move up from their rock bottom levels. It has been argued by many in the past that the extraordinarily low rates prevalent in the US and other parts of the developed world will not last forever, but no one perhaps anticipated the manner in which the reversal would begin.
Global bond markets lost more than $1 trillion in value last week as yields went up after Donald Trump won the race to the White House. Yields are rising as the new administration in the US is expected to pursue growth-oriented policies by stepping up infrastructure spending, cutting taxes and running a higher budget deficit. Consequently, the yield on 10-year US government bonds has gone up from the level of 1.83% in the beginning of the month to the present level of 2.23%. The yield on the 30-year bond has also moved up by about 40 basis points.
Expansionary fiscal policy at a time when US labour market is tightening could lead to higher inflation, which would mean that the Federal Reserve will have to raise interest rates at a faster pace than earlier anticipated. For now, markets expect the Federal Reserve to raise rates in December, followed by two more hikes in 2017. Economists are revising their forecasts for growth, inflation and interest rates upwards after the election.
The expectation of higher growth and a stronger dollar is attracting funds to the US which has resulted in hardening of yields in different parts of the world, including Europe. Some analysts are calling this as an end of the bull run in the global bond market. If interest rates rise significantly in the US, it will become somewhat difficult for central banks in other parts of the world to maintain rates at ultra-low levels, as capital will flow to high-yielding US securities.
However, a sudden and sustained rise in US bond yields could lead to significant volatility in the global financial market, especially in emerging market economies because of capital outflows. For instance, continued selling by foreign institutional investors has pulled the Indian stock market down by about 5% since Trump’s victory.
To be sure, bond market reaction in part is also a reflection of uncertainty. Things will become clearer once Trump and his team begin to talk about policy priorities in greater detail. For instance, it is not clear as to what extent the administration will be willing to push budget deficit and if the spending will be sufficient to sustain economic growth in the medium term. There is a fair amount of uncertainty regarding economic policy in general. During the campaign, Trump talked about protectionist policies and getting tough on immigration. He argued in favour of higher tariff on imports from several countries and said that he would declare China a currency manipulator.
Such policies in the present circumstances could result in a trade war and possibly trigger a global recession. He is also not in favour of trade deals such as the Trans-Pacific Partnership. Again, the idea is to be able to impose higher tariffs and bargain for a better deal from trading partners. There are also a number of geopolitical issues where the US has high stakes and a major shift from the past can have economic implications for both the US and the global economy. More clarity on some of these issues will probably emerge in the coming weeks which will also shape medium-term expectations in the financial markets.
Meanwhile, the Indian economic-policy establishment should start thinking about how to engage with the new dispensation in Washington, even as there is bipartisan consensus on cooperation with India. Trump has done business in India and addressed the Indian community during the campaign. He is wary of China and has spoken against Pakistan. All this should place India in a better position while taking forward India-US economic relations. But Trump’s protectionist ideas could affect Indian exporters, particularly in the technology business, and the issue of H-1B visas could again be a potential source of friction.
While the financial markets are preparing to adjust to possible changes in economic reality, soon policymakers in most parts of the world will also have to begin the process. India would do well to start preparing for the new economic order.
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